Why are bond price and interest rates inversely related?

Bond price and market interest rate always move in opposite directions. When interest rate in the markets fall the price of existing bonds rise. Conversely when market interest rates are rising market price of existing bonds fall. The operating word here is market. Interest rate referred to is not bond coupon rate but interest rate expected by market investors, and price is not bond issue price rather price at which investors are willing to buy existing bonds.

We know that once issued a bond's coupon rate (its interest rate) remains constant. Since bonds are tradable bondholders can sell bonds to interested buyers. Here the concept of yield comes into play. If however interest rate expectation of market changes (due to factors such as inflation), and interest rate on new bonds is different from existing bonds then buyers would not be interested to buy the first bonds at the same price. If market interest rates are going up then bond buyers would buy existing bonds at a lower price, since they carry a lesser coupon rate.

This is easier to understand with an example. Assume you bought bonds of price Rs 10,000 with coupon rate 8.5%. Later if you want to sell the bonds and market interest rate on new bonds is 9% then obviously buyers would want a discount for buying your bonds.


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